Challenges and Solutions to Environmental Tax Reforms

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Challenges and Solutions to Environmental Tax Reforms

Uitdagingen en oplossingen voor milieugerichte

belastinghervormingen

Proefschrift

ter verkrijging van de graad van doctor aan de

Erasmus Universiteit Rotterdam op gezag van

de rector magnificus

Prof.dr. R.C.M.E. Engels

en volgens besluit van het College voor Promoties

De openbare verdediging zal plaatsvinden op

donderdag 9 juli 2020 om 15.30 uur

door

Dirk Heine

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Promotiecommissie

Promotoren:

Prof.dr. M.G. Faure LL.M.

Prof.dr. A. Heise

Overige leden:

Prof.dr. S. Oded

Prof.dr. L.A. Franzoni

Prof.dr. S.E. Weishaar LL.M.

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This thesis was written as part of the European

Doctorate in Law and Economics programme

An international collaboration between the Universities

of Bologna, Hamburg and Rotterdam.

As part of this programme, the thesis has been submitted

to the Universities of Hamburg and Rotterdam to obtain

a doctoral degree.

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Barrieren und Lösungsansätze für ökologische Steuerreformen

Für eine deutschsprachige Zusammenfassung dieser Dissertation, siehe Anhang B.

Uitdagingen en oplossingen voor milieugerichte belastinghervormingen

Voor een Nederlandstalige samenvatting van dit proefschrift, zie bijvoegsel C.

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Nomenclature

BTA Border Tax Adjustment

CBD Convention on Biological Diversity

CBDR Common But Differentiated Responsibilities (under the UNFCCC) CCS Carbon Dioxide Capture and Storage

CGE Computable General Equilibrium (class of macroeconomic models) CO2 Carbon dioxide

CORSIA Carbon Offsetting and Reduction Scheme for International Aviation (of the ICAO)

CP Conference of the Parties (to the UNFCCC) CPF Carbon Price Floor

CS Consumer Surplus EKC Ecological Kuznets Curve ETR Environmental Tax Reform ETS Emissions Trading Scheme FCPF Forest Carbon Partnership Facility

FLEGT Forest Law Enforcement, Governance and Trade FSC Forest Stewardship Council

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G20 Group of Twenty

GATT General Agreement on Tariffs and Trade GDP Gross Domestic Product

GHG Greenhouse gas

GSMA Groupe Speciale Mobile (international mobile phone coordinating body) ICAO International Civil Aviation Organisation

IEA International Energy Agency IMF International Monetary Fund IMO International Maritime Organisation IPCC Intergovernmental Panel on Climate Change IRR Iranian Rial (currency)

ISEAL International Social and Environmental Accreditation and Labelling Alliance

LPG Liquefied petroleum gas

MARPOL International Convention for the Prevention of Marine Pollution from Ships

MRN Movement Reference Number (in customs processes) MRV Veasuring, Reporting and Verification (of emissions)

NCTS New Computerised Transit System (of the EU Customs Union) NDC Nationally Determined Contribution

NMPC Nonlinear Model Predictive Control (macroeconomic modeling tech-nique)

NOx Nitrogen oxides

ODI Overseas Development Institute

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PEFC Programme for the Endorsement of Forest Certification Schemes PES Payments for Ecosystem Services

PIT Personal Income Tax

PM2.5 Ultrafine particulate matter with a diameter below 2.5 µm PPP Polluter Pays Principle

PS Producer Surplus R&D Research & Development

Ramsar Ramsar Convention on Wetlands of International Importance espe-cially as Waterfowl Habitat

REDD+ Reducing Emissions from Deforestation and Forest Degradation and the role of conservation, sustainable management of forests and en-hancement of forest carbon stocks in developing countries

SO2 Sulphur dioxide

TFEU Treaty on the Functioning of the European Union

UNFCCC United Nations Framework Convention on Climate Change

US-IAWG United States Inter-Agency Working Group on Social Cost of Carbon USD US Dollar

VAT Value-added Tax

VOCs Volatile Organic Compounds VPA Voluntary Partnership Agreement WHO World Health Organisation WTO World Trade Organisation

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Part I

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Chapter 1

The need for Finance

Ministries to engage in

environmental law

1.1 Institutional responsibilities for

environmental damage

Law categorises societal issues into spheres of responsibility for different insti-tutions, such as the division between issues that fall under the responsibility of the courts as opposed to government. Once an issue has been determined to be the government’s responsibility, one still has to determine which administration within the government is in charge of the issue. Within governments, respons-ibilities are not only defined by hard public law, but also by soft law, such as the administrative schedule of responsibilities through which cabinet allocates soci-etal issues to different line ministries. Each of these institutions, in turn, has legal competence for different types of policy instruments.

Economics, meanwhile, has tended to disregard the association of policy instru-ments and institutional responsibilities and compare the relative efficiency of

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dif-Chapter 1. The need for Finance Ministries to engage in environmental law ferent policy instruments, as if policymakers could freely choose between them. For example, many economists have found that taxes are more efficient at redu-cing environmental problems than regulations. Such purely economic analyses can have limited political applicability if a country has given the administrative responsibility for all environmental issues to an Environment Ministry, but the responsibility for all decisions of tax policy to a Finance Ministry. In this case, the Environment Ministry may not actually be in a position to act on the policy recommendation. Such mismatches could imply that environmental policy is un-dertaken with the wrong policy instruments, even when the efficiency advantages of other instruments are known, just because those are outside the scope of re-sponsibility for the ministry in charge of the topic.

Once the scopes of responsibility for societal issues and policy instruments are set up, they can become entrenched. Law and Economics scholars should, there-fore, periodically reconsider if the institutional setup is adequate, or if there could be substantial efficiency gains from change. A good indicator to establish if such changes would be desirable is whether the nature of the societal problem in ques-tion has changed in significant ways since the areas of responsibility have been allocated.

Governments are routinely organised in “line ministries” that deal with sectoral issues, and “central ministries” that deal with cross-sectoral problems. The latter includes the Executive Office of the Head of State, in some countries a Planning Commission, and in all countries a Finance Ministry. Finance Ministries are re-sponsible for tax policy and for non-monetary economic problems that affect the stability of the economy as a whole. Line ministries, by contrast, are allocated to topics that can have broad societal impacts but that are not perceived as a core macroeconomic risk. Usually, these ministries are in charge of regulation and sectoral expenditures, but not of tax policy.

At the time in which environmental policy emerged, environmental problems were seen as such a sectoral issue, and were therefore allocated to a new line ministry. Subsequently, two discoveries occurred. New environmental problems that do impact the macroeconomy evolved – in particular climate change – and economists have increasingly pointed out the cost advantages of tax policy as an instrument for controlling environmental damage. Both discoveries call for schol-ars of Law and Economics to re-investigate if the allocation of competences should not be reconsidered so that also the Finance Ministry assumes a co-responsibility

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1.2. Environmental problems pose macro-size economic risks for this societal issue. This chapter, therefore, collects the evidence that climate change is indeed a macroeconomic risk, so that it requires the attention of the central ministry responsible for the cross-sectoral stability of the economy as a whole.

1.2 Environmental problems pose macro-size

economic risks

Climate change is happening, and it is progressing significantly faster than pre-viously expected. Over the earth’s history, the climate has always varied, but based on data records reaching back 800,000 years, we know that atmospheric greenhouse gas concentrations have never before risen as fast as in the last 150 years. Within that geological time span, the year 2016 has seen the fastest in-crease in those concentrations (World Meteorological Organization, 2017). Since modern precision temperature recordings started in 1880, the year 2017 has been the hottest years on record, with the 10 warmest years ever recorded all occur-ring after 1998 (Blunden et al., 2017). “It is extremely likely [95-100 %] that human influence has been the dominant cause of the observed warming since the mid-20th century. For the warming over the last century, there is no convincing alternative explanation supported by the extent of the observational evidence” (U.S. Govern-ment Inter-Agency Global Change Research Program, 2017, p. 12). “Geological records show that the current levels ofCO2correspond to an ‘equilibrium’ climate last observed in the mid-Pliocene (3–5 million years ago)” (World Meteorological Organization, 2017, p. 1), meaning that humans have no experience of adapting their economic systems to changes of this scale; it is an experiment without pre-cedent, with everyone in the test tube.

The damage from climate change is rising and may spiral out of control. To see that we are dealing with macroeconomic risks, it is critical to understand that climate damage may come in both a smooth, gradual type, as well as an abrupt, discontinuous type. Scientifically, there is “very high confidence in the potential for state shifts” (U.S. Government Inter-Agency Global Change Research Program, 2017, p. 33) in which the climate system passes tipping points to unleash pos-itive feedback mechanisms of escalating damage, meaning that beyond certain threshold warming levels, the costs of climate change may accelerate abruptly. If

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Chapter 1. The need for Finance Ministries to engage in environmental law human action increases temperature levels beyond certain levels, these increases may trigger positive feedback mechanisms in the climate system which would cause additional, autonomous warming. This additional warming may then spiral out of control, implying that these tipping points could be points-of-no-return. “The further the Earth system departs from historical climate forcings, and the more the climate changes, the greater the potential for these surprises” (U.S. Government Inter-Agency Global Change Research Program, 2017, p. 34). “Their consequences could be high, potentially exceeding anything anticipated by climate model projec-tions for the coming century” (id., p. 412). “Therefore, there is significant potential for humanity’s effect on the planet to result in unanticipated surprises and a broad consensus that the further and faster the Earth system is pushed towards warming, the greater the risk of such surprises” (id., p. 34). If these bifurcations are assumed away, “society may be lulled into a false sense of security by smooth projections of global change” (Lenton et al., 2008, p. 1792).

Avoiding the crossing of climate tipping points is critical from the point of view of macroprudential policy. It is not certain at which levels of temperature increases these tipping points lie. Based on the scientific consensus (IPCC, 2014), the inter-national community has agreed to translate its legal objective to “avoid dangerous anthropogenic interference with the climate system” (UNFCCC, 1992, Art. 2) into the commitment to contain global warming to “well below 2 degrees Celsius” (2015 Paris Agreement, Art. 2). For Finance Ministries, the concept of a tipping point is, of course, familiar. Through macroprudential policies, they seek to contain the risk of unleashing crises, knowing that, once triggered, a crisis can be much more expensive to stabilize than the costs of policies to prevent it. For climate change, stabilization might even be impossible (IPCC, 2014) leading to a fat-tailed prob-ability density function for disastrous outcomes (Weitzman, 2011), so there is a clear macroprudential logic to stay on the safe side of tipping points.

Even before any tipping points are hit, climate shocks impose severe macroeco-nomic damage. Besides the future risk of abrupt increases in cost shocks, climate change also causes more gradual costs. Also these gradual costs are expected to rise over time, partly because greater warming causes disproportionately greater damage and partly because “the physical and socioeconomic impacts of compound extreme events (such as simultaneous heat and drought, wildfires associated with hot and dry conditions, or flooding associated with high precipitation on top of snow or waterlogged ground) can be greater than the sum of the parts (very high

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confid-1.2. Environmental problems pose macro-size economic risks ence)” (U.S. Government Inter-Agency Global Change Research Program, 2017, p. 33). The external cost of carbon is therefore commonly modelled as increasing exponentially over time (US-IAWG, 2013), informing the target to contain global warming to 2°C. Also based on these smooth cost increases, it is widely agreed that the benefits of mitigating and adapting to climate change several times ex-ceed the economic costs of such policies (e.g. Stern, 2006).

It is impossible to achieve climate macro-stability without implementing mit-igation policy in almost all countries. Quantitatively, it is impossible to stabil-ize the climate without substantial mitigation efforts in all large countries, even poor ones where other economic concerns are most pressing. “Staying below a 2°C temperature increase implies that the global carbon budget has to be limited to 800GtCO2. This means that by 2050 almost 90 % of coal, half of gas, and two-thirds of oil reserves have to remain unburnt” (Edenhofer et al., 2017, p. 463), which is impossible without significant climate action including in developing countries where most of the current coal-intensive development is occurring. However, the world is quickly running out of time, as even current and planned coal power plants alone will exhaust half of the remaining carbon budget by 2030 (Edenhofer et al., 2017), in particular in countries where a lack of environmental taxation makes such investments lucrative.

In the Paris Agreement, almost all countries have therefore committed to climate change mitigation. This is a massive structural change in emerging climate law, because – before the Agreement – only developed countries faced binding ob-ligations to reduce emissions. Given their historic responsibility for past emis-sions, their greater economic ability to shoulder the abatement costs, and their higher per-capita emissions, developed countries are expected to cut emissions more deeply than developing countries (UNFCCC Art. 3), but all countries party to the Paris Agreement have now made a binding commitment to contribute to this mitigation effort through their Nationally Determined Contributions (NDCs). Failing to implement these climate commitments, in developed and developing countries alike, would almost certainly push global warming above 2 °C, and to-wards potential tipping points. “Achieving global greenhouse gas emissions reduc-tions before 2030 consistent with targets and acreduc-tions announced by governments in the lead up to the 2015 Paris climate conference would hold open the possibility of meeting the long-term temperature goal of limiting global warming to 3.6 °F (2 °C) above pre-industrial levels, whereas there would be virtually no chance if net global

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Chapter 1. The need for Finance Ministries to engage in environmental law emissions followed a pathway well above those implied by country announcements” (U.S. Government Inter-Agency Global Change Research Program, 2017, p. 32). Countries’ climate plans (NDCs) must, therefore, be implemented.

Implementation, in turn, will require Finance Ministries to take a central role, for several reasons. The NDCs are inherently cross-sectoral, which requires co-ordination across line ministries. Finance Ministries will invariably play some of that coordination role through their function as managers of the budget allocation process. In many countries, Finance Ministries are also responsible for long-term Public Investment Management, and NDCs often contain long-term public invest-ments. The implementation of NDCs is furthermore expected to be very costly, thus affecting Finance Ministries in their core mandate of ensuring sustainable fin-ancing. Lastly, the transition to low-carbon climate-resilient development implies a substantive structural shift in economies, so the macroeconomic consequences need to be managed, again pointing to Finance Ministries. And more mundanely, implementing deep economic transitions requires political power, which Finance Ministries clearly wield unlike Environment Ministries, particularly of developing countries.1_{This perspective that Finance Ministries have a large co-responsibility} for the implementing the NDCs is increasingly being shared by these ministries themselves.2

1.3 The choice of policy instrument

If Finance Ministries accept a co-responsibility for climate change mitigation, the question poses itself which policy instrument they will use.

Since Finance Ministries are responsible for the state of the economy as a whole, there will always be many other concerns for them besides environmental issues.

1_{The last point is based on interviews of the author with the administrators of long-standing country}

assistance programs for environmental reforms which the World Bank provides to developing coun-tries. Experience with such programs over the last 10 years suggests that the involvement and support of Finance Ministries is critical for ensuring the successful implementation of large environmental programs in poor countries.

2_{For example, at the World Bank in 2017, 30 Finance Ministries supported a call for fiscal reforms to}

implement the Paris Agreement (World Bank, 2017a). At the European Council, EU Finance Minis-tries recognized that the implementation of the Paris Agreement requires reforms to price carbon (European Council, 2017).

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1.3. The choice of policy instrument Clearly, there can be trade-offs between the implementation of the climate com-mitments and other economic issues. Any such trade-offs can motivate political delay, with the aforementioned financial implication that the total cost of imple-menting the Paris Agreement increases dramatically. Politically, it is therefore essential to find policy instruments that minimise such trade-offs between the environment and the economy. Minimizing those trade-offs requires using the least-cost mitigation policies and designing mitigation policies such that they con-tribute to achieving other (non-environmental) economic objectives like equitable and stable growth. In a recent study for the World Bank, Heine & Black (2019) review 30 years of research on the economic effects of a particular mitigation instrument – environmental taxation – to find that this instrument does enable Finance Ministries to jointly reduce emissions while enhancing economic devel-opment, and that this instrument should thus form the core of Finance Ministries’ role in climate change mitigation. That study,3_{which draws on this thesis,} elab-orates that there are over 30 channels through which environmental tax reforms can create a “double dividend”.

Choosing environmental taxation as the main mitigation instrument is also well in line with climate law. Scholars in the economic analysis of law have long emphasised the need for lawmakers to use economically efficient policy instru-ments. For climate policy, lawmakers appear to have listened and enshrined cost-effectiveness as a legal principle in the founding text of emerging climate law. UNFCCC Art. 3 explicitly requires that “policies and measures to deal with climate change should be cost-effective so as to ensure global benefits at the lowest possible cost”. However, climate lawmakers refrained from a definition of cost-effective in-struments. Instead, the Paris Agreement sets quantity objectives for the amount of mitigation that must be achieved, and lets each country decide individually what it considers to be the nationally appropriate mitigation instrument. Many economists have suggested that environmental taxation features amongst the most efficient mitigation policies (e.g. Acemoglu et al., 2012; Fullerton, 2001). “Revenue-neutral shifts toward environmental taxes can have extremely low or neg-ative costs, even when carbon taxes are implemented unilaterally” (Liu, 2013, p. 668). In the next chapter, we will, therefore, review to what extent environmental tax-ation is an efficient policy that Finance Ministries can use individually to achieve their national mitigation objectives.

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Chapter 1. The need for Finance Ministries to engage in environmental law

1.4 The need for policy mixes

The importance of environmental taxation does not mean that other policy in-struments do not have central roles to play for the sustainability transition. Even when a government uses environmental taxation and other market-based instru-ments optimally, there are remaining market failures inhibiting the sustainability transition (Seto et al., 2016), and some of these market failures are best addressed using sectoral regulations or expenditure policies (Grubb et al., 2014b). At the most basic level: environmental taxation should not be used in cases where the optimal quantity of the harmful activity is zero, which instead call for bans. More generally, a government which seeks to minimize the cost and maximize the ef-fectiveness of the sustainability transition should integrate environmental taxes within a wider policy package.

For example, to decarbonize the transport sector, the effectiveness and equity of a tax on motor fuels at reducing pollution are improved if it is combined with pub-lic investments to expand pubpub-lic transport systems, and vice versa (Avner et al., 2014; Gillingham & Munk-Nielsen, 2019). In this case, the joint impact of pursu-ing both policies is greater than the sum of their parts. The same is often true for combining environmental taxation with public support for green innovation (Acemoglu et al., 2012). Conversely, policies can also undermine each other. For example, a country that uses green bonds, feed-in-tariffs or regulations to raise the share of renewable energies in the electricity market and that simultaneously covers competing fossil fuel energy sources with an ETS, needs to beware of po-tential negative interaction effects. The policy measures pushing renewables into the market may reduce the scarcity of emissions permits under the ETS, thereby reducing the market carbon price, which in turn raises emissions (Fischer et al., 2016). In such a situation, the joint impact of several interventions can be less than the sum of their parts. It is then critical for governments to investigate and manage interaction effects and carefully embed fiscal policies into the wider sus-tainability governance framework.

An important first step to improve the capacity of governments to manage these interactions is transparency. A tested reform to build this transparency is “cli-mate budgeting”. The idea here is that Ministries of Finance aggregate and track all the expenditure programs of sectoral ministries related to climate change and tag these expenditure lines in the central budget. As climate change affects so

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1.4. The need for policy mixes many sectors, it is presently difficult for many governments to identify overlaps or contradictions of expenditure programmes and track the efficient use of funds (Fozzard et al., 2014; Jorgensen et al., 2014). Transparently including this inform-ation in the central government budget supports cross-sectoral coordininform-ation. Cli-mate budgeting is also useful to break the path-dependency that often surrounds ministerial budget allocations, because it provides a more informed shared refer-ence point for negotiations between finance and sectoral ministries on whether the budgets allocated to climate-related expenditures are adequate for the policy objectives sought.

Climate budgeting can be further improved by incorporating information on tax expenditures. In many countries, there are large tax expenditures supporting pro-duction techniques which contradict sustainable development objectives. More recently, tax expenditures are also growing for supporting green goals. The two types of special rules can contradict each other without anyone realising and in-crease the complexity of the fiscal system. Since the relative prices determine incentives for private markets to invest in the sustainability transition, the simul-taneous provision of tax expenditures for both high- and low-carbon technologies also increases the overall transition cost. Tax expenditures can also weaken the institutional capacity of governments and the democratic process for achieving sustainability transitions. This is because tax expenditures are often excluded from government budgets (OECD, 2010a), and thereby escape the scrutiny of the budget review process in Parliaments and public debate. Public surveys indic-ate that many people believe renewable energies are heavily subsidised whereas certain fossil fuels like lignite are not, when the playing field is instead tilted to-wards the latter, just through support systems that the public has greater difficulty understanding. Such misconceptions of fiscal support systems undermine public support for sustainability transitions. Fiscal authorities can enable informed pub-lic debate and consistent popub-licymaking by transparently including tax expendit-ures that act for or against sustainability objectives in the budget. Such account-ing practices do not need to upset standard budgetaccount-ing mechanisms such as overall expenditure estimates where changes might have repercussions elsewhere in the fiscal system (e.g. in budget deficit calculations). Legally, this information can be included in a separate budget annexe while still fulfilling its transparency func-tion.

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Chapter 1. The need for Finance Ministries to engage in environmental law has an important role for environmental mitigation objectives. But budgets also matter for adaptation. Here it is the annexes to the budget that governments standardly use for tracking fiscal risks which have a role to play in the sustain-ability transition. As climate change impacts all sectors, it is difficult for a cent-ral government to have a consistent aggregate view of climate impacts for the economy as a whole. Since Finance Ministries are tasked with macroeconomic policymaking and as the guardian of public finances, they have a role to play in assembling this information from line ministries, and tracking the adequacy of adaptation investments and policies to respond to these challenges. The central budgeting mechanism is a powerful instrument for such cross-sectoral coordina-tion, and fiscal risks are an action-oriented way to go from quantifying and clas-sifying to managing contingent climate damages.

Whereas such fiscal reforms can accelerate sustainability transitions and reduce their costs, successful implementation is a large governance challenge. Environ-mental fiscal policy is data-intensive and requires technical capacity in an area that is still foreign to most finance ministries. The solution often involves closer collaboration with line ministries. For example: In tax policy, the environmental effectiveness of excise duties can be improved by letting rates vary according to the sustainability of production methods. But doing so requires a lot of data and enforcement capacity that only line ministries, and in some cases non-state actors, have. In expenditure policy, public investments can be made more sustainable by incorporating environmental and social “shadow costs” (as the European Com-mission has long recommended),4 _{and in several EU Member States individual} ministries have calculated such shadow costs, but their use – and even knowledge of their existence – tends to vary a lot across ministries.

Sometimes Finance Ministries have taken shortcuts to reduce the need for com-plex coordination, capacity building or appraisals. These shortcuts can come at a cost to the efficiency and effectiveness of sustainability transitions. For example, to support green innovation, a standard policy has been to extend one-size-fits-all tax expenditures which provide the same deductibility for broad types of R&D investments. These policies reduce administrative cost and the problem of “pick-ing winners” but have often led to the leakage of fund“pick-ing to unintended uses and sometimes worsened corporate tax base erosion. Recently, the European Commission floated a strategy calling for a fundamentally different approach, in

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1.5. Focus which public investments take a much more active role in pursuing innovation “missions” (Mazzucato, 2019, 2018a). Such a “green entrepreneurial state”5_might yield great benefits for growth and value creation,6_{but requires significant} gov-ernance capacity, and not only great collaboration between ministries but new governing frameworks for collaboration with the private sector, too. The lesson might then be that advanced approaches to governing sustainability transitions can improve outcomes but must be backed up by sufficient capacity. If the ca-pacity is not available, a simpler but robust framework might be preferable, and an assessment framework might help governments determine their situation: to choose approaches or determine capacity gaps for handling the approach that was chosen.

An example for such choices is the decision between implementing environmental fuel tax policies “upstream” (where fuels enter the economy – e.g. mines, wells, ports, pipeline border crossings), “midstream” (at fuel processing units – e.g. re-fineries) or “downstream” (at the point of fuel combustion – e.g. chimneys). Tradi-tionally, Europe has used upstream approaches for standard fuel taxes but down-stream approaches for carbon pricing and environmental regulations. As envir-onmental considerations are integrated more deeply into standard tax policy, the question arises which of these two approaches should be used. The downstream approach can create superior environmental incentives but involves higher ad-ministrative and compliance cost. For countries with constrained governance ca-pacity, shifting upstream can help reduce these costs as well as evasion (Liu, 2013) and leakage to the informal sector (Bento et al., 2018; Markandya et al., 2013). The improvement of evasion and informality issues can drastically reduce the cost of environmental policy - this thesis will shed light on how practically this can be done.

1.5 Focus

We have highlighted the need for Finance Ministries to engage in certain macro-scale environmental problems. We then described the need for fiscal policies to be embedded in policy packages, with roles for complementary regulations, public

5_{Mazzucato (2018b)}

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Chapter 1. The need for Finance Ministries to engage in environmental law investment, and other frameworks – below we will often refer to liability system. These complementary policies are important, but that is also widely recognised in the literature. Furthermore, there is, of course, no doubt about the importance of Environment Ministries for environmental policy of course. This thesis recog-nises the importance of those other policy instruments and institutions, but sets a focus on Finance Ministries because there is much less guidance on their envir-onmental role, which – notwithstanding the continued relevance of Environment Ministries – is currently becoming acutely important. Most of the 51 Finance Ministries that last year committed to deep environmental fiscal reforms through the Coalition of Finance Ministers for Climate Action are completely new to this policy field.

Simultaneous to the recent movement of Finance Ministers, also the economics community made a big shift. A recent statement of 27 Nobel laureates called for tax policy to take the main role in the global fight on climate change, instead of other regulatory approaches. Akerlof et al. (2019) point out that “A carbon tax offers the most cost-effective lever to reduce carbon emissions at the scale and speed that is necessary.” “A sufficiently robust and gradually rising carbon tax will replace the need for various carbon regulations that are less efficient. Substituting a price signal for cumbersome regulations will promote economic growth and provide the regulatory certainty companies need for long-term investment in clean-energy alternatives.” Finance Ministries are hearing these calls on their tax policy, but many questions abound. This thesis seeks to use the author’s involvement in these policy dialogues to identify relevant barriers and potential solutions to this greater use of environmental taxation, while respecting – as emphasized above – the need for policy packages and environmental policy through other institutions.

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Chapter 2

The efficiency case for

environmental taxation

∗

This chapter investigates in more detail whether tax policy really is an efficient environmental policy instrument, and focuses in particular on the efficiency of using fuel taxes to mitigate climate change and air pollution.

2.1 Internalisation of externalities

The fundamental purpose of environmental taxation and emissions trading sys-tems (which are jointly known as “carbon pricing” in their applications to climate change) is to make consumers and producers of polluting goods take into account the costs imposed by this pollution on society as a whole.

∗_{Contents from this chapter have been published in the journal article Heine, Dirk, Semmer, Willi,}

Mazzucato, Mariana, Gevorkyan, Arkady, Radpour, Siavash, & Hayde, Erin. 2019. Financing Low-Carbon Transitions through Low-Carbon Pricing and Green Bonds, Vierteljahreshefte zur

Wirtschafts-forschung, 88(2), p. 29-50, and the book chapter Heine, Dirk, & Black, Simon. 2019. Benefits beyond

Climate: Environmental Tax Reform. in Pigato, Miria (ed.), Fiscal Policies for Development and Climate

Action.Washington DC: World Bank Publications, as well as coverage related to the 2019 Award of

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Chapter 2. The efficiency case for environmental taxation

2.1.1 Foundation of free markets

Although the roots of this “cost internalisation” are commonly attributed to Pigou (1932), the need for free markets to internalise social costs has been agreed upon for much longer. Already Adam Smith pointed out that the very idea of forcing third parties to bear the cost of a private exchange contradicts the idea of a free market.1 _{He also pointed to the efficiency of taxation as a policy response,} sug-gesting that carriages in England should be taxed in proportion to the damage they cause to roads and therefore to other road users (Smith, 1776, p. 481). More formally, the First Fundamental Theorem of Welfare Economics showed that in order for a free market to generate a Pareto-efficient competitive equilibrium, ex-ternal costs must be inex-ternalised (Arrow, 1951; Lange, 1942; Lerner, 1934). A root motivation for cost internalisation is thus that free economic markets re-quire all exchanges in the economy to be voluntary, between freely consenting trade partners. Third parties must not be forced to pay for external costs arising from transactions. Market economies are meant to reward those who create net value, rather than those who merely redistribute value in zero-sum or negative-sum games. When the production of a good causes pollution, the costs of that pollution must, therefore, be paid by those taking the decision to produce and consume the product, rather than by unrelated third parties. Otherwise, produ-cers and consumers can forcibly redistribute welfare from those third parties to themselves. Without bearing the full costs of their actions, such producers and consumers have an incentive to carry out transactions even when those trans-actions cause net harm to society because of the external costs borne by their victims. To safeguard the core principles of liberty and net value creation, eco-nomic agents must, therefore, bear the full costs of their own actions. Pricing environmental damage contributes to this cost internalisation.

1_{“It is unjust that the whole of society should contribute towards an expense of which the benefit is confined} to a part of the society” (Smith, 1776, section 1.4). “In the race for wealth, and honours, and preferments, [man] may run as hard as he can, and strain every nerve and every muscle, in order to outstrip all his

competitors. But if he should justle, or throw down any of them, the indulgence of the spectators is

entirely at an end. It is a violation of fair play, which they [society] cannot admit of” (Smith, 1759,

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2.1. Internalisation of externalities

2.1.2 Internalisation through liability

The internalisation of environmental damages can be achieved through differ-ent means than taxes, such as through emissions trading systems (ETS) and the private enforcement of property rights in courts. The latter option looks appeal-ing, as it avoids direct government intervention. When the production of a good creates pollution that harms a third party, this person might in principle take the producer or consumer of the good to court to seek compensation for that harm. Unfortunately, even in the most developed economies with well-defined property rights, the transaction costs of legal proceedings would be prohibitively high in many pollution cases, in particular for greenhouse gases. CO2has a vast number of emitters, whose scentless effluences mix invisibly and spread globally. The location of most damage caused by a given source of emissions is outside the jurisdiction where this source of emissions is located, and the global warming caused by a molecule of CO2persists for about 100 years after it is emitted (Stocker et al., 2013). This implies that the polluters and their victims do not know each other, mostly live under different judicial systems, and may live in different time periods. For practical purposes, it is often impossible for victims of climate change to take those harming them to court.

Coase, therefore, gives air pollution as an example where government interven-tion can improve efficiency. “This would seem particularly likely when, as is nor-mally the case with the smoke nuisance, a large number of people are involved and in which therefore the costs of handling the problem through the market or the firm may be high” (Coase, 1960, p. 18).

2.1.3 Normative Coase Theorem

Even when the private property rights solution does not offer a viable solution, it can nevertheless greatly inform public policy. Following the Normative Coase Theorem (Parisi, 2007), the government should set a carbon price that coincides with the price that freely negotiating emitters and victims of climate change would have reached if they were able to meet in an ideal court setting. Rational private parties, bargaining on a level playing field, would set the carbon price at the level of the marginal damage that the carbon emissions cause the victim.

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This rate, which would be reached through the first-best bargaining process (Coase, 1960), coincides with the definition of an optimal environmental tax (Pigou, 1932). Let us elaborate this point further.

Coase explains which price would be reached in a bargain between a person suf-fering from an activity that imposes a harmful effect and the person emitting that effect. If the victim holds the right to the absence of this harmful effect, the max-imum price that the victim can ask is bound by the counterparty’s profit from continuing the activity, and the minimum price that the victim will accept is the value of the damage itself.2_{Initially, the price can vary within that range, but for} bargains undertaken in perfect competition, Coase points out that the bargaining price for the right to continue the harmful effect would converge to the opportun-ity cost of using that right in its next best use.3_{For example, if the harmful activity} is pollution, the opportunity cost of selling the right to emit the pollution would be the victim’s otherwise avoidable health costs. Pigou, similarly, defines the op-timal tax on an activity that generates external costs as the difference between the marginal social net product of the activity (“the aggregate contribution made to the national dividend”)and the marginal private net product. Like Coase, Pigou specifies that the opportunity cost of any uncompensated resources has to be sub-tracted from the value which the activity in question adds to total production (“the aggregate contribution made to the national dividend”). In this way, both Coase and Pigou make very strong computative demands, as they both refer not only to the cost that the parties impose on each other, but also on the economy overall. Note that this commonality is not how Coase interpreted Pigou in his article, which substantially deviated from Pigou’s actual writing,4 _{but reflects where both}

au-2_{Coase makes this point using the example of a bilateral externality between a cattle-raiser whose}

steers impose damages on the produce of a neighbouring farmer. If the farmer negotiates the price for which he would grant the cattle-raiser the right to continue to let his steers stray, “the farmer would not be able to obtain a payment greater than the cost of fencing off this piece of land nor so high as to lead the cattle-raiser to abandon the use of the neighbouring property. What payment would in fact

be made would depend on the shrewdness of the farmer and the cattle-raiser as bargainers. But as the payment would not be so high as to cause the cattle-raiser to abandon this location and as it would not vary with the size of the herd, such an agreement would not affect the allocation of resources but would

merely alter the distribution of income and wealth as between the cattle-raiser and the farmer” (Coase,

1960, p. 5).

3_{“In conditions of perfect competition, the amount which the farmer would pay for the use of the land is}

equal to the difference between the value of the total production when the factors are employed on this land and the value of the additional product yielded in their next best use (which would be what the farmer would have to pay for the factors)” (Coase, 1960, p. 6).

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2.1. Internalisation of externalities thors’ actual writings agree.

Outside of perfect competition, the parties in a Coasean bargain could diverge from the above price-setting mechanism; a “victim” who sells its right to be free from a damage could demand more compensation than the value of the damage incurred.5 _{A Pigouvian tax, however, would continue to be set according to the} damage imposed. In this way, the Pigouvian tax rate is either equal or less inter-ventionist than the price achieved in a Coasean bargain because the tax rate only covers the damage, whereas under a Coasean bargain, the victim may be able to (under non-competitive circumstances) make a gain from trade.5

The Pigouvian approach to set the compensation at the lower bound is, in fact, an incentive for victims from social costs to first seek an agreement with the persons creating these external costs before seeking recourse in a tax solution. Another incentive comes from the fact that in the case of a Coasean bargain, the com-pensation payment is being transferred between the bargaining parties (so the victim can be personally compensated) whereas in the case of a Pigouvian tax, the money goes to the general public, represented by the taxman. From a neo-classical efficiency-standpoint, these outcomes are equivalent, but they provide an incentive to individuals to use Coasean bargaining when possible and to re-sort to Pigouvian taxation only as a solution of public policy when the bargaining over rights does not function.6

question arises as to what he is doing in the[Coase 1960] article at all” (Simpson, 1996, p. 74). “When

several or numerous third parties are concerned, the Coasean and Pigouvian approaches are neither totally different nor opposite to one another, but rather are complementary” (Slaev, 2017, p. 952).

5“What payment would in fact be made would depend on the shrewdness of the farmer and the

cattle-raiser as bargainers” (Coase, 1960, p. 5).

6_{The reason why the efficiency consequences of compensating victims directly (Coasean bargain) and}

compensating the general public (Pigouvian tax) are equal, is that the standard social welfare function used in Law and Economics treats the welfare of the victim and the welfare of another person in society as perfectly substitutable. Posner (1985), for example, suggests that the economic objective of law should be the maximisation of wealth, which assumes a social welfare function which adds up the wealth (or utility) of individuals without social weighting. Coase makes the same assumption in his definitions of efficiency and his normative suggestions for the objectives of law. In the same vein, Pigou assumes that damages caused to an individual victim can be compensated through transfers made to the taxman as a representative of the public at large. In this way, he assumes that the victim does not need to be treated differently from the standard taxpayer. This approach again uses the same social welfare function as the one implied by Posner and Coase.

That said, it is possible to adapt Pigouvian taxation to treat the welfare of the victim differently from the welfare of the general taxpayer. Pigou suggests attributing a greater change in social welfare to money losses of the poor compared to money losses of the rich. In most countries, the average tax-payer is richer than the average person in society, and environmental damages are borne more by the

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Summarising, the Pigouvian tax rate would be set equal to or below the rate that freely bargaining individuals would achieve if they were able to negotiate about the social cost in question. Therefore, carbon prices at the Pigouvian level can-not be labelled as “interventionist”. They are rather the consequence of taking property rights seriously in cases where bargains on social cost are not always possible so that fall-back policy options are needed.

2.2 Cost-efficiency relative to regulations

In addition to carbon pricing, the internalisation of environmental costs can also be achieved through regulatory instruments. Price-based instruments do, how-ever, have lower costs.

2.2.1 Equalisation of marginal abatement costs

One reason for this cost advantage is that environmental taxes and emissions trading systems (ETS) allow firms with different abatement costs to vary in the intensity of their emissions cuts. A profit-maximising firm will reduce its carbon emissions to the level at which its private marginal cost for achieving these emis-sions reductions equals the carbon price. A firm that can abate at a low cost will undertake greater emissions reductions than a firm that finds reducing emissions expensive. As a result, firms equalise their marginal abatement costs rather than their abatement quantity. The emissions reductions occur where they are least expensive, minimising the economy-wide cost of climate change mitigation (e.g. Ackerman & Stewart, 1985; Buchanan & Tullock, 1975). Compare this outcome in carbon pricing with the counterfactual outcome under a regulation in which each firm is mandated to achieve the same quantity of carbon mitigation. In the latter case, some of the cost advantages of firms with cheaper carbon mitigation opportunities remain unused, and the overall climate target is reached at a higher cost.

poor than by the rich (see chapter 12.3.2). These concerns can be incorporated into Pigouvian taxation by adjusting the tax rate accordingly, as well as through the use of the revenue (chapter 12.4.2).

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2.2. Cost-efficiency relative to regulations

2.2.2 Scope of emissions reduction opportunities

A related cost advantage of carbon pricing policies – such as environmental tax-ation or ETS – over regultax-ations is the scope of emissions reduction opportunities (e.g. Aldy et al., 2010; Krupnick et al., 2010). For example, a carbon price provides electric power stations with an incentive to switch to cleaner generation fuels (“input substitution effect”) and reduce exhaust (“abatement effect”), while sim-ultaneously providing an incentive to consumers to purchase goods using less electricity (“output substitution effect”; e.g. Sterner & Coria, 2012). By contrast, a regulation mandating that power stations install emissions treatment equipment (e.g. carbon-capture-and-storage or scrubbers for sulphur dioxide) forgoes most of these wide-ranging incentives. Achieving the same overall emissions reduc-tion target with a higher number of mitigareduc-tion opportunities lowers overall costs. Furthermore, the state becomes less intrusive, since a carbon price leaves private agents the freedom of choice of how to achieve emissions reductions, rather than mandating a particular way of doing so.

2.2.3 Dynamic efficiency

These cost advantages also hold over time. Consider a regulation that requires power plants to reduce their carbon emissions below a certain benchmark value. After a power plant achieves this standard, it has no incentive to keep improving. If the regulation is replaced by carbon pricing, the power plant faces a dynamic incentive to continue exploiting cost-efficient opportunities for further emissions reductions (Sterner & Coria, 2012).

2.2.4 Revenue recycling

As a by-product of their environmental purpose, environmental taxes generate public revenues. These revenues can be used to lower other taxes, either dir-ectly – for example, by reducing personal or corporate income taxes, reducing la-bour overhead costs, compensating losers – or indirectly – by financing a budget consolidation that would have otherwise required other taxes. In either case, this revenue-recycling effect of environmental taxes produces another efficiency gain that is unavailable with regulations.

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The size of these efficiency advantages from revenue recycling depends on how the revenues are used. Heine & Black (2019) provide an in-depth analysis of the different policy options to maximise these gains under different country circum-stances.

2.3 Vulnerability to government failure

2.3.1 Misunderstanding between Coase and Pigou

Correcting market failures such as climate-change risks may not work well if there are also government failures (Tullock et al., 2002). This problem was at the forefront of Coase’s concerns with Pigouvian taxation, although the two authors appear to have had much the same position about the need to balance risks of market and government failure.7 _{Three safeguards for protecting environmental} taxation against government failure have been suggested.

Firstly, Pigou suggests scrutinising whether the government has the administrat-ive capacity to efficiently enforce environmental taxes before introducing them.8 We will return to the steps required for implementing this safeguard in chapter 11 where we set out how environmental taxes can be adapted to situations of low government capacity.

7_{Above we pointed out features that make Pigouvian taxes comparatively non-interventionist.}

How-ever, Coase’s interpretation of Pigou was that “economists, under the influence of Pigou and others, thought of the government as waiting beneficently to put things right whenever the hidden hand pointed

in the wrong direction” (Coase, 1995, p. 30). Coase strongly opposed such interventions on the ground

that “governmental administrative machine is not itself costless. It can, in fact, on occasion be extremely

costly”(Coase, 1960, p. 18), so that interventions such as through Pigouvian taxation would lead to

“results which are not necessarily, or even usually, desirable” (id., p. 2). Pigou did, however, share these views and argued that it was essential to be prudent in using taxation to address social costs. “It is not sufficient to contrast the imperfect adjustments of unfettered private enterprise with the best adjustment

that economists in their studies can imagine. For we cannot expect that any public authority will attain, or will even whole-heartedly seek, that ideal. Such authorities are liable alike to ignorance, to sectional pressure and to personal corruption by private interest” (Pigou, 1932, pt. II, ch. XX, para. 4). As a result, “Pigou’s view was thus much the same as that of Coase, though he was marginally less skeptical about the merits of state action” (Simpson, 1996, p. 73).

8_{“In any industry, where there is reason to believe that the free play of self-interest will cause an amount} of resources to be invested different from the amount that is required in the best interest of the national

dividend, there is a prima facie case for public intervention. The case, however, cannot become more

than a prima facie one, until we have considered the qualifications, which governmental agencies may be expected to possess for intervening advantageously” (Pigou, 1932, pt. II, ch. XX, para. 4).

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2.3. Vulnerability to government failure Secondly, Pigouvian taxes should only be imposed on externalities for which the size of damages has been quantified with sufficient certainty. Studies that calcu-late Pigouvian taxes for real-world policy advice therefore routinely exclude en-tire categories of damages which are known to exist but for which data is scarce (e.g. NRC, 2009; Parry et al., 2014; Stern, 2016), to purposefully rather err on the side of “non-interventionism” than vice-versa. As a result, the risks of inefficiently intervening through taxes are kept in check, although there is an increased risk of type-II errors.9

2.3.2 Risk of governance failure under environmental

taxes relative to alternative policy instruments

The third safeguard against government failure is the choice of the policy instru-ment itself. This section extends the analysis in Posner (1992, p. 378f.).

The approach here is to find which policy instruments can correct market fail-ures at the least risk of causing government failure. Consider first regulations and then carbon pricing. When the government decides for businesses whether a new clean technology should be introduced, both the costs of introducing the technology and the benefits of reducing emissions require analysis. With car-bon pricing, by contrast, the government only requires information about the marginal damage caused by carbon emissions and not about the marginal costs of abating these emissions (Posner, 1992, p. 378f.). The government leaves it to businesses to compare the benefits of emissions reductions (as expressed by the carbon price) and their costs. Policy can then be efficient even if the government lacks half of the information required for a cost-benefit analysis.

The last argument – that carbon pricing policies such as environmental taxes require only the quantification of costs whereas regulations require the quantific-ation of costs and benefits – corrects an error of Coase. Coase (1960, p. 43f) had suggested that governments should undertake full analyses of costs and benefits before any policy intervention on social costs. He intended this advice to reduce the risk of government failure. However, his recommendation would imply that

9_{A type-II error is defined as failing to reject a false null hypothesis. It is also known as a "false} negative" finding. In this application, the policymaker needs to decide whether the evidence base is strong enough for including a given social damage in the calculation of a Pigouvian tax. The null hypothesis is that an activity or substance does not cause an external damage.

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the state (either through government or courts) undertakes wide-ranging invest-igations into both the costs and benefits of various private sector activities. Such a dominant role for the state effectively amounts to a public plan selecting which private activities the state finds useful and which not, which is the opposite of Coase’s intention to avoid a planned economy. The finding of Posner (1992, p. 378f) – that environmental taxes only require the evaluation of the social costs from activities while leaving it to private decision-makers to determine the private benefits of these activities – then implies that the use of environmental taxes, as opposed to Coase’s approach, reduces the amount of information that govern-ments need to raise and leaves more decisions to private market participants.10 The risk of government failure is reduced accordingly.

2.3.3 Corruption and evasion

Two other risks of government failure are corruption and evasion. It is, however, possible to design environmental taxes in a way that enables those taxes to per-form better than classic environmental regulations towards each of these types of government failure. Here we briefly explain how this tax design works, and in chapter 11 we provide details on how this tax design can be implemented in vari-ous country circumstances even when the government has a low administrative capacity.

Most greenhouse gases and air pollution are associated with the combustion of fuels, and fuels are generally easy to tax because they enter the economy at only a small number of points such as refineries, the entry points of pipeline systems at ports or border crossings. At this ‘upstream’ stage of the supply chain, the fuels are typically handled by a few, huge, formal-sector entities. Each of these features implies that the revenue collection for upstream environmental taxes is much easier to supervise, audit and protect against evasion than it is for most tra-ditional taxes which attach to physically smaller or invisible monetary tax bases and charge a much greater number of small taxpayers who are spread out across the economy. The fact that fuels are also dangerous and strategically essential

10_{For air pollution cases, Coase explicitly favoured regulations over taxes and justified this based}

on taxes requiring the government to collect more information Coase (1960, p. 41). However, it is precisely the information requirement that favours taxation over regulation since regulations require a full cost-benefit analysis instead of only an analysis of the costs.

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2.3. Vulnerability to government failure means that their flows are already closely tracked by governments in most coun-tries. It is also easier to supervise fuel taxes compared to other tax bases like income flows for the simple reason that fuels as a tax base are physical, volumin-ous, and therefore harder to conceal and shift to other jurisdictions than money streams.

The enforcement of regulations on emissions standards has almost the opposite characteristics. The number of chimneys to regulate is much greater than the entry points of fuels to the economy. So the amount of (technically trained) gov-ernment personnel required to supervise a pollution regulation can be enormous. Furthermore, the government may need to send auditors across the country to check compliance with regulations, including to remote regions where many less developed countries can have a scarcity of technically qualified controllers. By contrast, upstream fuel taxation can be executed in just a few central points. The need for a person-to-person interaction between an auditor and a person who is being controlled can thus be much smaller with this type of taxation than with regulations. When the government uses environmental fuel taxes instead of reg-ulations it can accordingly concentrate its supervision over a small number of officials who impose a carbon price at a few fuel entry points to the economy, and the climate policy covers all subsequent activities using these fuels. It is then private trade partners who pass the environmental tax price signal through the market, to the remote regions, to the informal activities, to all industries. Each private agent has an incentive to enforce the price signal with his transaction partners fully, given the private incentive to pass on a tax incident, so the public policy benefits from voluntary private enforcers where it lacks public ones. In chapter 11, we consider some additional complexities when countries use other types of environmental taxation. However, the bottom line here is that upstream environmental taxes are more robust against corruption and evasion than regu-lations. Upstream environmental taxes are furthermore more robust against eva-sion than other taxes, such as personal income taxes. Liu (2013) estimates the size of these benefits in a macro model in which countries use the revenues from environmental taxes to reduce their pre-existing taxes. The model is calibrated using cross-country data on evasion for the different tax types. Liu (2013, p. 656) finds that “In countries with high levels of pre-existing tax evasion, a carbon tax will pay for itself through improvements in the efficiency of the tax system”.

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2.3.4 Informality

Government failure is also associated with the informal sector (or “underground economy”), and again environmental taxes can reduce this problem, creating ef-ficiency gains.

The existence of an informal sector is a major legal problem, for example when people illegally engage in business activities and then cannot enforce a contract or labour rights in courts. Informality is an example of government failure in the sense that government taxes are a significant incentive for workers and firms to become informal (La Porta & Shleifer, 2014). This avoidance reaction, in turn, raises the costs which most taxes pose to the economy (Piggott & Whalley, 2001).11 However, when environmental fuel taxes are implemented upstream, they impose the tax at a choke-point in the supply chain where the economy is almost entirely formal.12 _{From this choke-point, the tax incidence is passed through the entire} economy, charging both the informal and the formal sector. A shift from tra-ditional to environmental taxes can, therefore, broaden the tax base for raising revenue, and it can also reduce the fiscal system’s disincentive to join the formal sector for efficiency gains.

Designing an environmental tax so that it covers the informal sector alongside the rest of the economy drastically reduces the cost of policy. In the United States, the informal market only accounts for 9 % of GDP, but even then, the cost of mitiga-tion efforts to formal sector output is reduced by 62 % when the environmental tax

11_{Informality adds another margin through which taxed entities can avoid taxes. Whereas in classical}

computations, for example of the optimal personal income tax, individuals can react by reducing their labour supply, they can now also shift their labour supply to the informal sector. The optimal personal income tax rate is accordingly lower. Raising more public revenues is a more substantial challenge then, because raising the rates of traditional broad-based taxes may push additional people into the informal sector (Duncan & Peter, 2014). These distortions from today’s tax systems are well documented in many countries (e.g. Bruhn & Loeprick, 2016; Gatti et al., 2014; Benhassine et al., 2016; Mele, 2017).

On a higher level, informality prevents the economy from allocating resources optimally because in the presence of informality, “allocation is determined not by productivity but by ‘fiscally effective’

productivity” (Markandya et al., 2013, p. 109). Each of these factors mean that there could be large

gains from reducing the bias of traditional taxes favouring the informal sector. To reach this objective of better covering the informal sector, various other, (non-environmental) tax strategies have been tried, but with limited success (Benhassine et al., 2016; Dube & Casale, 2016)

12_{Unless a country uses significant amounts of fuelwood or informal waste incineration (which is the}

case in some developing countries) or where a country has a lot of cross-border fuel smuggling. For the cases, see Heine & Black (2019).

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2.3. Vulnerability to government failure covers the informal sector compared to when it does not (or compared to macro models which assume that no informal sector exists) (Bento et al., 2018). In Spain, which has an informal sector share of around 20 % of GDP, introducing a carbon tax equivalent to a 15 % emissions reduction would cause official GDP to rise by 7 % and official unemployment to fall by 3 % (Markandya et al., 2013). Country studies for China, India, and Iran suggest that accounting for the existence of informal markets is sufficient to make environmental tax reforms a policy that increases GDP (Bento et al., 2018; Carson et al., 2019; Mirhosseini et al., 2017).

2.3.5 Conclusion on government failure

Coase (1960) had suggested that environmental taxation may pose too substan-tial risks of government failure and instead favoured private bargaining solutions, “doing nothing”, or regulations. Here we suggest that environmental taxation is more robust than regulations against government failure and more robust than some core non-environmental taxes against evasion and informality. The implic-ation is that environmental taximplic-ation is a more, not less, efficient environmental policy instrument for countries with greater risk of government failure.

This finding does not mean that government failure is not a critical concern. It remains true that countries must balance efforts to correct market failure with the risk of government failure. However, if countries do act on environmental problems, the risk of governance failure is an argument for choosing environ-mental taxes over regulations. Furthermore, when countries contemplate “to do nothing” about environmental problems, they need to consider that they already have other, non-environmental taxes and that a tax shift from these other taxes to environmental taxes can help them reduce evasion problems of their fiscal sys-tems. These additional efficiency gains provide a non-environmental reason to introduce environmental law, and to do so through Pigouvian taxes.

While environmental taxes then do not have a major vulnerability to the risk of government failure, it is still important to implement these taxes in a least-risk manner. Chapter 11 sets out how this can be done in high-risk countries.

Challenges and Solutions to Environmental Tax Reforms